Jeffrey Butler, Director
Most of us are not familiar with how an installment sale works. An installment sale is a transaction structured whereby the seller receives payments over a period of time rather than all at once. It can be beneficial to both the buyer and seller. In addition to making it easier for the buyer to afford making the purchase, an installment sale can provide an income tax management opportunity for the seller.
According to the IRS, an installment sale is a sale of property where the seller receives at least one payment after the tax year in which the sale occurred. The seller will report the installment sale in the year the sale occurs, but not include the entire gain in taxable income in that year. Each year an installment payment is received, only the part of the gain proportionate to the sales proceeds received is included in income. This spreads the seller’s income tax liability over the life of the installment agreement instead of having to incur the entire tax burden at once, in the year of the sale. Even though an installment sale is being used, the seller still may maintain a security interest in the property. This will not negate the tax advantages of spreading the gain over multiple years.
An installment sale can be structured with great flexibility. Payments can begin or end whenever both parties’ desire and should include interest. The interest rate must be above the applicable Federal rate (AFR) and reasonable for both parties. It can be structured to encompass easy payments for the buyer and ensure a steady income stream to the seller. The seller can plan the payment schedule to defer income to a year when being in a lower income tax bracket is anticipated. For example, if the seller is currently employed but will retire in five years, the agreement can be structured for payments to start after retirement. By deferring payments to years when the seller is no longer working, the marginal rate on the income received can be lower than when the seller was employed.
The advantages do not just favor the seller. The interest paid by the buyer can be tax deductible if the asset acquired is business or investment property, or a principal residence. Further, the buyer gets a stepped-up basis in the assets when purchased. Therefore, if depreciable property is acquired, the new asset can be depreciated at the higher value which will help to offset any income the buyer might earn from the asset.
As any other advantageous strategy, there are some installment sale pitfalls to be aware of. Planning is essential so negative consequences do not occur. For starters, installment sale rules do not apply to sales that result in a loss. In addition, you cannot use installment sales to report income from the sale of inventory or stocks and securities traded on an established securities market.
Special care needs to be taken in the sale to a related party or a member of your family. To determine an arms-length value of the property to be sold, a respected independent third party appraiser should be hired. If it can be determined that the property was sold at less than fair market value, a gift is considered to be made for the excess of the FMV over the present value of the installment payments. Furthermore, if the interest rate charged is less than the applicable federal interest rate, gift taxes may also be due.
Another unintended outcome when selling to a related party is when the property is sold by the related party within two years of the first disposition. The tax rules are very complex and your tax advisor should be consulted to avoid negative tax consequences.
Installment sale treatment is not allowed when depreciable property is sold to certain controlled entities. These entities include a partnership or corporation where the seller has more than 50% of ownership interest. For tax purposes, all payments due to be received are considered to be received in the original year of sale.
Finally, a tax concept known as depreciation recapture may come into play. If personal property is sold (also known as Section 1245 property) any gain on the sale is treated as ordinary income to the extent of depreciation allowed or allowable on the property. If real property is sold (also known as 1250 property) any gain on the sale is treated as ordinary income to the extent of additional depreciation greater than depreciation calculated using the straight line method. Even if no money is received by the seller in the year of sale, depreciation recapture will be reported as taxable income by the seller and added to the seller’s basis of the property. This reduces the gain reported each year as installment payments are received by the amount of the depreciation recapture. Contact your KOS Advisor if you have any questions.